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S Corps Control Social Security and Medicare Taxes

When a law firm is taxed as an S Corp, the primary tax savings are achieved by controlling social security and medicare taxes.

Law firm owners must pay the social security and medicare taxes withheld from employee paychecks and they must pay the social security and medicare taxes matched by the employer.

For 2014, Social Security and Medicare taxes consist of:
6.20% Employee Portion for Social Security (6.2% of first $117,000)
6.20% Employer Portion for Social Security (6.2% of first $117,000)
1.45% Employee Portion for Medicare (1.45% of all net income)
1.45% Employer Portion for Medicare (1.45% of all net income)
—
15.3% Total

Schedule C and Partnership Self-Employment Tax

When a law firm is taxed as a sole proprietorship (Form 1040, Schedule C) or a partnership (Form 1065) all net income is subject to self-employment tax.

Example
Law firm taxed as sole proprietorship on Form 1040, Schedule C.
Law firm net income is $150,000.
...

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Choosing to be taxed as an S Corp does trigger several additional costs.

Payroll Service

S Corp owners are required to receive wages through payroll checks.  If the law firm does not have a payroll services in place, a payroll service must be started.

Unemployment Taxes

Once the firm owner is on payroll, their wages are subject to state and federal unemployment taxes.  Arizona unemployment rates start at 2% of the first $7,000 of wages for an annual total of $140.  Federal unemployment taxes are .6% of the first $7,000 of wages for an annual cost of $42.

Workers Compensation Insurance

Most states allow business owners to opt out of the worker’s compensation insurance that is normally required for all employees.

Income Tax Preparation Costs

Filing an S Corp Tax return is more complex than filing a schedule C.

All additional costs are tax deducible.

All of the above costs are tax deductible.  If the owner’s federal and state tax rate is 35%, a...

What’s a reasonable salary for the owner of a law firm?

The IRS won’t specifically define reasonable, there are only guidelines.  The IRS notes that the courts have considered the following facts when reviewing salary levels:

• Duties and responsibilities.
• Time and effort devoted to the business.
• Dividend payment history.
• Payments to non-owner employees for similar work.
• Timing and manner of paying bonuses to key people.
• Payment by comparable businesses for similar services.
• Compensation agreements.
• Usage of a formula to determine compensation.

Thankfully, you’ll find a wide pay range that you can prove to be reasonable.  A top indicator is the amount that your firm would pay a third-party employee to do the job.  You can find documentation in job ads, trade surveys, from headhunters, or internet services like Salary.com or PayScale.com.

The key is documenting proof of a reasonable salary by gathering facts to support the salary taken,...

Gathering tax documents is such a joy. Having to store the documents for several years is even more joyful. How long do you need to wait before getting rid of tax documents?

Suggested Retention

• Tax returns, supporting schedules, and W-2s should be kept forever.  The documents may be needed to prove earnings and credits when applying for social security.
• Receipts, bank statements, and other supporting documents should be kept for at least six years.  If the IRS accuses you of under reporting income, they can audit six years of tax returns.
• Documentation for fixed assets, depreciation, and amortization should be kept for six years, but the receipt date is effectively the date the asset was sold or disposed of.

When does the Clock Start?

The six year retention clock starts on the due date of the filed tax return, not the date on the receipt.  If a tax return is extended, the retention period begins with the due date for the extended return.  To make things simple,...

Most likely, no.  The exact answer depends on the type of tax return filed for the law firm.

Firms that file as C Corps (Form 1120)

Firms that file as C Corps are able to directly deduct donations made to charity.  However, charitable donation deductions are limited to a maximum of 10% of net income.  Since most small C Corps are run to report nearly $0 taxable income each year, they are unable to deduct charitable donations.  Disallowed charitable donation amounts are lost and cannot be carried forward or transferred to shareholders.

Firms that file as S Corps (1120S), Partnerships (1065), and Sole Proprietors (Schedule C)

A little better news, but still not the answer most people expect.  For these firms, charitable donations are transferred from the firm and reported as itemized deductions for the owners.  The donation can be reported on the law firms financial statements, but the donation amount is removed from deductible expenses when the income...